The effect of regulatory oversight and the audit firm on the
nature of key audit matters in the new auditor’s report
Master thesis, MSc Accountancy
University of Groningen, Faculty of Economics and Business
January 21, 2019
Sander Knol
Student number: S2380501
Vierde Drift Noorderhaven 8 KMR3
9712 AH Groningen
Tel.: +31634345798
E-mail: s.t.knol@student.rug.nl
Supervisor: Robert Tuinsma
1 ABSTRACT
Resulting from the financial crisis and heavy criticism from the public on audit reporting, new standards were imposed to increase the informational value of the auditor’s report. This paper investigates the relationship between regulatory oversight and the nature of key audit matters (KAM’s) disclosed in the new auditor’s report and the relationship between Big 4 audit firms and the nature of KAM’s. Using the chi-square test of independence, it was found that regulatory oversight has a significant impact on the nature of KAM’s, even after controlling for firm size. The audit firm, however, seems to have an effect on the nature of KAM disclosures only for big clients. The results indicate that the newly imposed standards have differential effects between countries, which is important to realize for standard setters and can affect the way implement new standards are implemented. Furthermore, financial statement users benefit from the evidence that audit firms influence KAM disclosures, as these affect the way financial reports are used.
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INTRODUCTION
As a result of the financial crisis in 2008 the audit quality and the work of auditors were heavily criticized and there has been a call for more transparent and informative auditor reports by the users of financial statements (EY 2016). The public felt that auditors appeared to have failed to report about the possible effects of significant risks that companies were exposed to (Richard 2008). Also, auditors are required by the UK auditing standards (and also by similar international standards) to consider the ability of an entity to continue its future operations as a going concern (Auditing Practices Board 2004a, p. 8). Despite this, in some cases companies went bankrupt or experienced severe financial difficulties after receiving an unqualified audit opinion. An example is Lehman Brothers, who received an unqualified opinion in 2008, but went bankrupt in July of the same year. Bear Stearns, the fifth largest investment bank in the US, also received an unqualified audit opinion in January of 2008, but turned out to be in severe financial trouble only two months later (Sikka 2009).
This raises the question what the role of the auditors was during the crisis and how it was possible that entities received unqualified audit opinions, yet collapsed only a few months later. According to research by Doogar, Rowe and Sivadasan (2015), accountants failed to warn about the crisis and the related risks in companies not because of their awareness of or attention to those risks, but rather because of limitations in accounting and auditing rules. The public debate on the role of auditors in the financial crisis has caused standard-setting organizations to make changes to model of the auditor’s report, in an effort to improve society’s confidence in financial reporting and to improve the information environment for stakeholders (Kiss et al. 2015). Currently, the majority of countries that use the ISA’s have adopted the new standard. Under the new standards, auditors are required to provide more and better information about their approaches and judgements, so that financial statement users can gain a better understanding of the auditors’ understanding and insights about the audited entity (FRC 2016). The need for better communication by auditors is not just a result of the financial crisis, but also of a general discontent about the informational value of auditor’s reports (Eumedion, 2013). The auditor’s report is the only piece of evidence of the work that the auditor performed and for years this was a standardized text with no company-specific information, containing only generic statements and the opinion of the auditor on whether or not the financial statements presented a true and fair picture of the company. However, stakeholders desire more informative auditor’s reports, so that they can gain a better understanding of the work and judgments of the auditor (Eumedion 2013).
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Under the new standards, the revised auditor’s report is required to contain: 1) key audit matters (KAM’s1) that were identified by the auditor; (2) the auditor’s responsibilities
regarding the going concern assumption of the audited entity; (3) the application of materiality; and (4) the scope of the audit (FRC 2016). According to a report by the FRC (2016), investors find the enhanced focus on Key Audit Matters in the auditor report the most important aspect of the new extended auditor report regime. Moreover, in an evaluation by Eumedion (2015), it became apparent that sometimes the information in auditor’s reports related to the financial situation of companies is more informative than management reports and reports of the supervisory board, which highlights the importance of the new auditor’s report. The addition of KAM’s in the auditor’s report has given the auditor the ability to draw the attention of the readers of financial statements to the relevant issues. This is because auditors determine which matters are included in the auditor report. Moreover, the readability of financial statements and annual reports has decreased in the last couple of years due to the increased size of annual reports (Backhuijs and Roelofsen 2014), which contributes to the attention-drawing ability of auditors. This is the reason that the new auditor’s report not only provides more information related to the work of the auditor and the audit, but it is also a useful additional source of information for financial statement users that can be used in conjunction with the information provided in the annual reports. These are also the reasons why Brouwer et al. (2016) view the addition of KAM’s in the auditor report as the most important new feature.
Therefore, this research focusses on the key audit matters, which responds the call for more research on this topic by Bédard et al. (2016). KAM disclosures were not previously required in the auditor’s report and because of its novelty, research examining KAM disclosures and the impact they have on financial statement users is still relatively scarce (Bédard et al. 2016). Existing research that covers this primarily focusses on the effect of KAM’s on certain topics (Velte 2018). In other words, the KAM’s are used as the independent variable. There are three areas in which early evidence was found concerning the effect of KAM’s, namely: auditor liability (Gimbar et al. 2016), aggregated capital market reactions (Lennox et al. 2017) and individual investors’ decisions or assessments (Christensen et al. 2014). The abovementioned research all treat the KAM’s as an independent variable and to my knowledge very few research is done yet that looks into the explanatory factors of KAM’s. This is what makes this research different. The fact that many countries have now adopted the
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new standard has led to the opportunity to research the differences between countries related to the new auditor’s reports and the KAM’s included in them.
One of those differences concerns regulatory oversight. Regulation related to accounting and reporting can be quite different from country to country in several areas. For example, it can be determined by the government versus self-regulated, the structure and oversight of financial markets can vary and the oversight of the profession and certification of the professionals can differ (Gordon et al. 2013). In the economic literature, there are two models of regulation: public interest theory and special interest theory (Mulherim 2007). Public interest theory sees regulation as a reaction to market failure, where regulation has the purpose of improving social welfare. Special interest theory, however, views regulation as a response to political pressures. In this view regulation is aimed at protecting producers, instead of consumers (Stigler 1971). Due to this there is significant variation between countries concerning regulations and regulatory oversight. This is important, since regulatory oversight was found to have an impact on the quality of financial reporting and disclosures (Brown and Tarca 2007). Identifying KAM’s involves complex, challenging and subjective judgment by the auditor and are related to auditing accounts or disclosures that are material to the financial statements. Since these accounts and disclosures are influenced by regulatory oversight (Brown and Tarca 2007), it seems likely that regulatory differences between countries have an impact on the KAM’s that are reported in the auditor’s report.
Furthermore, since auditing standards such as the International Standards on Auditing are principles-based as opposed to rules-based, firms such as the Big 4 audit firms each have developed their own unique set of internal work rules and guidelines in order to be able to efficiently apply the standards on a day-to-day basis. This has resulted in what is defined as ‘audit style’ (Francis, Pinnuck and Watanabe 2014). The fact that each audit firm has its own style makes it possible that this results in each firm applying the new ISA 701, which requires the reporting of KAM’s in the auditor’s report, in their own way. This could result in differences between audit firms and the nature of the KAM’s they report. This has led to the following research question:
“What is the relationship between regulatory oversight and the audit firm on the nature of the key audit matters (KAM’s) in the auditor’s report.”
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THEORETICAL BACKGROUND Theory related to the auditor’s report
Concepts in the literature that are relevant to the auditor’s report and its contents are the audit expectation gap, information gap and communication gap. In the context of the auditor’s report, these gaps are the difference between what the auditor’s report could or should provide to stakeholders, and what they actually provide (Simnett and Huggins 2014).
Firsty, the audit expectation gap is defined as “differences between the public’s perceptions of the role and responsibilities of the auditor and the auditor’s perception of these roles and responsibilities” (Schelluch and Gay 2006). The audit expectation gap is a phenomenon that has been widely researched in the past and prior research indicates that this gap is still significant (Gray et al. 2011). Masoud (2017) agrees and argues that the audit expectation gap is a global and significant problem. According to Porter (1993), the audit expectation gap consists of two elements: the reasonableness gap and the performance gap. The reasonableness gap represents the gap between what the public expects auditors to achieve and what auditors can be reasonably expected to achieve. The performance gap is the gap between what the public can reasonably expect auditors to achieve and the public’s perception of the auditors’ achievements. This is relevant to the new auditor’s report, because in the past stakeholders have expressed legitimate concerns regarding how auditors have served the needs of investors. It was suggested by the press that auditors’ opinions were inordinately influenced by clients, to the detriment of the public interest (Church et al. 2008).
In relation to the auditor’s report, the second gap is the information gap, which is the difference between the disclosures that users would like to see, based upon which they can make good and informed investment and financial decisions, and the disclosures that the auditor’s report actually provides (Turner et al. 2010). The old standardized report was heavily criticized because it did not convey any useful information to users, and although the auditors possessed useful information about the company and its financial reporting processes, this was not disclosed in the auditor’s report (Brown and Trainor 2014; Simnett and Huggins 2014). The primary goal of the changes to the auditor’s report is closing the information gap (MARC 2011).
The third gap that exists is the communication gap. According to Mock et al. (2013) it ‘‘reflects differences between what users desire and understand and what is communicated by the assurance provider.’’ The information gap is different in that it reflects the perception of users that there is insufficient information about the entity and the audit process, whereas the
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communication gap relates to the effectiveness of the communication regarding the entity and the audit process (Simnett and Huggins 2014).
Context of the new auditor’s report
For a long time, the audit report and opinion were standardized and did not contain any company-specific information (Gutierrez et al. 2018). The general consensus among researchers and stakeholders is that the report evolved to be a standardized report with only symbolic value, containing no information of communicative value (Blake et al. 2011; Church et al. 2008; Turner et al. 2010). Financial statement users would like auditors to communicate more of their insights regarding the audit of an entity in the report, in order to enhance its relevance and usefulness (Gray et al. 2011; PCAOB 2013). Additionally, the terminology used in the ‘old’ report was sometimes misinterpreted, as well as the level of assurance that was provided by the auditor (Asare and Wright 2012). Also, in a survey by Carcello et al. (2011), experienced financial statement users expressed a desire to see additional disclosures in the auditor’s report concerning management’s significant estimates and judgments, as well as an overview of the most significant audit and financial statement risks and the related auditor’s response to address those risks.
As a result of these concerns, the Financial Reporting Council (FRC), the International Auditing and Assurance Standards Board (IAASB), the Public Company Accounting Oversight Board (PCAOB) and the European Commission (EC) implemented new standards that require the inclusion of KAM disclosures. All these new audit reporting initiatives are intended to enhance the users’ understanding of audited financial statements, by requiring disclosures with additional information regarding matters that the auditor finds useful to financial statement users or that the auditor also finds challenging (Mock et al. 2013).
Key audit matters
The new standards require the addition of KAM disclosures in the auditor’s report and this is seen as the most important new feature (Brouwer et al. 2016). Key audit matters have the purpose of communicating to users the matters that the auditor found to be of most significance during the audit of the financial statements (IAASB 2015; PCAOB 2017). Determining whether or not an audit matter is a key audit matter and should be reported is largely a matter of professional judgement, although the standards do provide guidelines to help the auditor with making those decisions.
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Next to closing the information gap, KAM’s can also serve another important purpose. Financial statement users have been found to underestimate and ignore, for example, important footnotes to financial statements (Schipper 2007). To help mitigate this, valuable information can be presented more prominently, since research has shown that prominent information attracts more attention from readers, because it requires less cognitive effort to notice salient information and to process that information (Files et al. 2009). By reading specific matters of importance, in this case KAM’s, the cognitive overload of users is decreased and users can more easily recognize relevant information in the financial statements (Mayer and Moreno 2003). This is the reason why, according to standard setters, including KAM’s in the audit report can help users navigate in the complexity of the financial statements and disclosures by increasing the prominence of potentially valuable and useful information (PCAOB 2013). In other words, KAM’s have an attention directing role. This is because KAM’s are unique to the specific entity that was audited, and as such they are more prominent than other parts of the report, since those are generic in nature and do not differ much between entities (Christensen et al. 2014). Additionally, research by Sirois et al. (2018) shows that financial statement users are guided by the KAM’s in the auditor’s report to read and review the relevant financial statement disclosures, since the KAM’s highlight matters of importance in the financial statements. They found that users paid more attention to disclosures related to the KAM’s in the report, which suggests that KAM’s can be used as a tool to influence how users find information in the financial statements and to influence to what matters the users pay the most attention. Therefore, it is important to understand the factors that have an effect on the reported KAM’s, as they have an effect on the way that financial statement users gather and interpret their information.
Previous research on KAM disclosures
Research examining the new KAM disclosures has primarily focused on the effects thereof, an exception being Velte (2018). He examined the effect of the percentage of women on audit committees on KAM disclosures, and found that a higher percentage of women results in a higher readability of KAM disclosures. Most research on KAM disclosures, however, examines the consequences of the new auditor’s report and KAM disclosures. There are three domains in which this research takes places: auditor liability, aggregated capital market reactions and individual investors’ decisions or assessments. The results of this line of research are mixed.
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Gimbar et al. (2016) performed a review of five studies focusing on the effect of KAM disclosures on auditor liability. They concluded that across all five studies auditor liability was reduced or not influenced by KAM disclosures. However, it was noted that auditor liability increased under two conditions: when the accounting standards were precise and when the auditor disclosed additional procedures performed as a response to the higher risk associated with the KAM. In the area of aggregated capital market reactions, it was found that the additional reported risks in the auditor’s report have no incremental information to investors (Lennox et al. 2017). Furthermore, Read et al. (2015) found a decrease in information asymmetry as a result of the new and expanded auditor’s report in the U.K. They examined the abnormal volume on the annual report’s release date and found that they increased in the first year after the implemented changes, which was interpreted as the new information being useful to investors. Opposing results were found by Gutierrez et al. (2018), who report that there was no short-term market reaction to the release of the auditor’s report on its public release date. In the area of individual investors’ decisions and assessments, Christensen et al. (2014) performed an experiment in which they examined investor decisions after providing them with different audit reports. They found that individual investors were more likely to change their investment decisions if they received KAM disclosures compared to investors who received an old version of the auditor’s report or the same KAM information in footnotes. Another study in this context was performed by Sirois et al. (2018), who investigated the effect of KAM disclosures on the information acquisition of financial statements users. They found that users paid more attention to items in the financial statements related to KAM’s in the auditor’s report, supporting the view that KAM’s have an attention directing role. Furthermore, they found that the number of KAM’s has a significant impact on the way users use the financial statements.
The nature of KAM’s
This study focusses on the nature of the KAM’s that are reported in the auditor’s report. This is an important aspect to study, since KAM’s play an important role in the way financial statements are used and information is acquired (Sirois et al. 2018). Furthermore, Brouwer et al. (2016) found that the KAM’s in the auditor’s report often match with the significant accounting policies and estimates that are reported in the notes to the financial statements. However, risks disclosed in reports from directors are only mentioned as KAM’s in the auditor’s report in 10 percent of the cases. Brouwer et al. (2016) also find have that KAM’s related to balance sheet items are most often included in the audit reports, whereas companies recognize other types of risks more often, such as reliability and continuity of IT systems and
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compliance with regulations. These types of risks are however, far less often mentioned as KAM. Sneller et al. (2017) looked into the informational value of IT-related KAM’s and found that they provide investors with useful information. A report by KPMG (2017) showed that by far the most common KAM relates to goodwill and related CGU assets such as intangibles and PPE. After that, but at some distance, revenue recognition related KAM’s are most common. This is in line with a report by the Association of Chartered Certified Accountants (ACCA 2018), which found similar results, but it used a slightly different typology than the KPMG report. The research underlying the ACCA (2018) report not only found that better information was provided for investors, but also that the financial reporting process improved. This is because KAM’s help auditors focus on the areas that require the most attention and judgment, which contributes to audit quality. Moreover, preparers of financial statements can use the KAM disclosures as guidance for where their reporting should be improved, which leads to better financial reporting. This is another reason why it is useful to explore the determinants of the nature of KAM’s in the auditor’s report.
Hypothesis development: regulatory oversight
A possible factor that might have an impact on the reported KAM’s in auditor’s reports is the differences in regulatory oversight between countries. In the economic literature, there are two main theories as to why these differences exist. On the one hand, regulation has the goal of improving the state of the public and increasing social welfare. Regulations come into existence as a consequence of market failure. This is called the public interest theory in economic literature and in this theory new regulation serves the consumer side of the market. Its counterpart is the special interest theory, which states that new regulations are politically motivated. In this view, regulation takes the side of the producers (Stigler 1971).
Oversight regulators have the task of monitoring, enforcing, penalizing and reporting non-compliance with the standards and guidelines. The purpose is to ultimately improve audit quality and to prevent potential audit failure. The inspections that regulators perform are focused on the behavior of the auditor, which results in incentives for auditors and firms to change their practices, in order to meet the requirements of the inspection (Church and Shefchick 2012).
Furthermore, an increase in regulatory oversight reduces information asymmetry, since closer and more extensive monitoring of entities results in the acquisition of more information. This reduces the need for external monitoring by the auditor (Bryan and Klein 2005). Research by Boo and Sharm (2008) found that the board and audit committee of an entity require less
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extensive external audits when regulatory oversight is high, which means that regulatory oversight can act as a substitute for the external audit. A similar effect was found on the side of the auditor by Bedard and Johnstone (2004), who found that auditors perform less extensive audits when their clients are under strict regulatory control, since this reduces audit and financial reporting risks. This might also have an impact on the work performed that is related to the disclosure of key audit matters, as the degree of regulatory oversight and its strictness influence the process and performances of auditors and the extent of the audit.
Regulatory oversight and differences between countries
Differences between countries exist in relation to financial reporting, as rules and regulations can be specific to a country’s needs and markets (Gordon et al. 2013). The way in which regulatory oversight is organized can vary, as in some countries this is self-regulated, while in others it is regulated by the government. The certification of auditors and the oversight of the profession is also an area in which differences exist between countries. Furthermore, financial markets can be structured differently and the oversight and rules and regulations can be adopted to the specific needs of the market (Gordon et al. 2013). These differences exist because of the way the rules and regulations come into existence, which is described in the public interest theory and special interest theory (Stigler 1971).
Before the revisions of the auditor’s report and the inclusion of the KAM’s, various research has shown significant differences exist between countries related to the standardized auditor’s report. For example, Archer et al. (1989) showed that only the standards of four European countries were perfectly harmonized with the international report. Furthermore, research by Lin and Chan (2000) showed that while China has adopted standards and guidelines that closely align with international standards regarding a number of important aspects, there are still areas in which differences exist. It is expected that these differences will remain to exist due to cultural differences (conservatism and uncertainty avoidance), a lack of formal training and limited competitive pressure on audit fees.
From the discussion of the literature above, the expectation arises that the specific regulatory oversight of a country leads to differences between the contents of auditor’s reports of different countries, specifically in relation to the key audit matters disclosed in the reports. The following hypothesis is:
H1: The regulatory oversight of a country has an effect on the nature of the key audit matters
11 Hypothesis development: audit firm
Another factor that might influence the nature of key audit matters in the report is the audit firm. As previous research has shown, individual auditors have a significant effect on audit quality (Gul et al. 2013; Alissa et al. 2014) and individual auditors seem to have their own, unique style (Aobdia et al. 2015; Amir et al. 2014; Knechel et al. 2015).
Firstly, concerning the effect of individual auditors on audit quality, Gul et al. (2013) examined this effect by using quality of audit reporting and the earnings quality of clients as proxies for audit quality and found that this effect was statistically and economically significant. In addition, it was also found that this variation in audit quality could be explained by a number of demographic auditor characteristics, such as Big 4 audit firm experience, political affiliation and exposure to western accounting systems (as opposed to Chinese accounting systems). The authors also noted that there might be numerous other auditor characteristics that affect auditor judgement and decision-making. Alissa et al. (2014), for instance, showed that effort and experience of the auditor increase audit performance and thus audit quality. These findings are in support of a survey that was conducted by Christensen et al. (2016), from which it became apparent that auditor characteristics are viewed by auditors and investors to be among the most important characteristics that influence the quality of the audit. This is because the work of auditors typically involve a large degree of judgment and this directly influences the audit quality. Therefore, better and more capable auditors result in higher audit quality (Knechel et al. 2013). The level of professional skepticism and knowledge and expertise are characteristics than can positively influence judgment and the subsequent audit quality. On the contrary, client retention and with-in firm economic pressures, which are client-related incentives, can have a negative effect on judgments and therefore audit quality (Knechel et al. 2013). This especially holds true for the new KAM’s requirement, as ISA 701 (IAASB 2015) states: “Determining the key audit matters to communicate in the auditor’s report is a matter of the auditor’s professional judgment.”
Some research also suggests that individual auditors have their own style. For example, the quality of individual auditors was found to be significantly related to their client’s earnings response coefficients, initial public offering underpricing and the cost of debt (Aobdia et al. 2015). Furthermore, audit partners with criminal convictions were found to have clients with greater governance, financial and reporting risks than their counterparts (Amir et al. 2014). Knechel et al. (2015) found that an audit partners aggressiveness or conservatism persists over time and affects all clients of the auditor. Some auditors were more likely to commit type I or type II errors consistently. These results indicate that auditors have a unique style.
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From the discussion above it can be concluded that individual auditors have their own style and can affect audit quality, or in other words, the outcomes of the work performed by auditors. The question then, is if this is also the case for audit firms as a whole.
In order to understand the differences between Big 4 audit firms, the organizational culture is an important aspect to consider. This is because audit firm culture is viewed by the auditing profession as an inherent part of a firm’s identity, which is used to distinguish a firm from other firms (Jenkins et al. 2008). Firms were more or less free to develop and cultivate their own culture freely to the extent that the marketplace and rules and regulations allow it (Jenkins et al. 2008). Organizational culture can result in the creation of a common identity and commitment from employees, a social order and continuity and the management of uncertainties that affect the firm as a whole (Trice and Beyer 1993). Furthermore, it is a way to control employees and to make sure that their behavior is aligned with the interests of the firm (Neimark and Tinker 1986). Firms need to ensure that new employees adapt to the firm’s culture, so that the quality of the work performed by the employee can be managed and so that their work complies with the policies and goals of the firm (Covaleski et al. 1998). This has accumulated into the fact that Big 4 audit firms have their own culture and set of internal working procedures that constitute its audit methodology (Francis, Pinnuck and Watanabe 2014).
Concretely, these unique cultures of audit firms have led to differences in the way audits are performed. Previous research, for example, found variation between the then Big 8 firms in terms of their audit approach. Firms were categorized on an unstructured versus structured continuum with respect to the audit technologies they used (Kinney 1986). Next to that, unique audit methodologies are used by firms to set themselves apart from competitors. In the 1980s for instance, there was a difference between firms using a qualitative versus a quantitative audit approach (Kaplan, Williams and Menon 1990). These differences exist because Big 4 firms have developed their own unique set of internal working rules and audit procedures, which is referred to as audit style (Francis, Pinnuck and Watanabe 2014). The reason for this is that many accounting and auditing standards are principles-based instead of rules based, such as the International Standards on Auditing (ISA’s). It is probably not very efficient to work with and apply principles-based standards on a daily basis. This is because of the significant judgment that is required for interpreting principles-based standards. Establishing working rules and guidelines creates consistency with the interpretation and implementation of the standards and its principles (Kothari et al. 2010). Each of the Big 4 firms has developed guidelines on how to interpret relevant standards for internal use, but they also offer these as a
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product to their clients. Each of these products are marketed differently, in order to distinguish themselves from competitors. It is likely that audit firms’ clients use this products when preparing their financial statements. It is also common that CFO’s seek help from their audit firm when complex accounting issues arise during the preparation of financial statements. It was found that this results in an increased comparability of financial statements for firms with the same auditor (Francis, Pinnuck and Watanabe 2014). To summarize, each audit firm has its own unique style and this is a source of variation between Big 4 auditors.
Due to the fact that the standards are interpreted by audit firms individually, it seems likely that differences might arise between audit firms concerning the audit outcome. There might be variations in how audit firms interpret the new standards related to the KAM’s and due to the different styles, it is possible that the audit firm has an effect on the nature of the KAM’s that are reported in the auditor report. This leads to the second hypothesis. In the null form, it is:
H2: The audit firm that performs the audit has an effect on the nature of the key audit matters
that are disclosed in the auditor’s report.
METHOD Sample selection
For this research the financial statements and auditor reports of in total 613companies were examined for the year 2017. The sample comprises companies listed on stock exchanges from Australia, France, Germany, Hong Kong, the Netherlands, Spain and the United Kingdom. However, some of those companies are headquartered in other countries than those listed above. Since the regulatory quality data related to those countries from Kaufmann et al. (2009) are known and data related to the audit firms of those companies are available in the dataset, those companies are included in the sample as well. The specific indices that the companies were retrieved from are: the ASX 100 (Australia); the CAC 40, CAC Next 20, CAC Mid 60 (France); the DAX (Germany), 110 companies from the Hang Seng Hong Kong LargeCap Index (Hong Kong); the AEX Index, the AMX index and the AScX Index (the Netherlands); the IBEX 35, the IBEX Medium Cap and the IBEX Small Cap (Spain); 100 companies from the Financial Times Stock Exchange 100 Index (UK).
Not every company listed on these indices was used in the final sample for this research. A small number of the auditors did not include a discussion of the KAM’s in their auditor report as was required by the new standards. Furthermore, the annual reports of a number of companies were unavailable. Next to that, some reports were only available in a foreign
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language, of which the data collectors had no sufficient knowledge needed to gather the data and to identify and interpret the KAM’s and their nature. Also, the companies that were listed on more than one of the indices were only included once, so that there exist no duplicates in the sample. Finally, in some cases data were unavailable due to a merger of those companies. For these reasons, the initial sample of 613 was reduced to 574. This sample was used to test H1.
In order to test H2, all French companies were excluded from the sample. This is because French companies are legally required to be audited by at least two auditors and the auditor report is signed by two different auditors. This makes it impossible to determine which KAM’s were chosen by which auditor and to examine the effect of individual audit firms on the nature of the KAM’s. Furthermore, H2 only tests audit firms that constitute the Big 4 audit firms: Deloitte, EY, KPMG and PwC. This is because the sample includes too few audit firms other than the Big 4 to make any meaningful inferences about. The sample used to test H2 therefore consists of 461 companies. The final samples and their composition are shown in table 1 for both H1 and H2.
15 Data
The data used in this research is from the year 2017 and was hand collected from the annual reports of the companies, which were retrieved from their websites, and put into the database manually. This means the data is reliable, since the data come from the original source. The data collection regarding the nature of the KAM’s was done by examining and reading each KAM and determining the category it should be put into. Appendix 1 shows these categories and subdivisions. The definition of the categories is based on what is mentioned in the KAM’s and if that can be traced back to the balance sheet or the income statement. If KAM’s could not be related to the balance sheet or income statement, other categories were defined based on the general characteristics of the KAM’s and commonalities between them. This is also the approach that was taken by Brouwer et al. (2016), who examined KAM’s in the auditor reports of a number of Dutch companies. In their research, they related KAM’s to
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1) balance sheet items; 2) profit and loss account; 3) financial statements – other; 4) internal control; and 5) other matters. Each of these categories was further specified into subcategories that related to specific balance sheet items or other matters. This research used the same approach, but the categories that were used are slightly different.
The categorization of the KAM’s is not entirely objective, since it involves a high degree of judgment from the data collectors and sometimes there was ambiguity as to how certain KAM’s should be categorized. However, the data was collected by Accountancy Master students and they therefore had sufficient knowledge and expertise to be able to determine the nature of the KAM’s and in which category they belong. Furthermore, to reduce the effects of the ambiguity and the differences between data collector’s that might have arisen, the data collectors were trained by an experienced researcher on how to categorize the KAM’s. Also, the data collectors collected data from five of the same companies and compared them with each other. Where differences had arisen between collected data that should have been similar, the data collection methodology was discussed in order to align those methodology and to avoid significant differences between data collection methods of the data collectors.
In order to test whether regulatory quality and the nature of the KAM’s are independent of one another, a chi-square test of independence was calculated comparing the frequency of KAM’s and their categories in high and low level regulatory quality countries. The same test was performed in order to test the relationship between the audit firm and the nature of the KAM’s.
Measures
Independent variables
Regulatory oversight is measured using the independent variable ‘regulatory quality’ (REGQ), using the work of Kaufmann et al. (2009). They created an index in which, among other things such as rule of law and other country-specific characteristics, regulatory quality is measured for individual countries. Their definition of regulatory quality is: “the ability of a government to formulate and implement sound policies and regulations that permit and promote private sector development . . . based on labor, tax, and trade regulations, freedom over prices and competition, investment climate, and other factors” (Kaufmann et al., 2009). Other measures of regulatory quality have also been used in previous studies (e.g. La Porta et al., 1997; Leuz, Nanda and Wysocki, 2003), but the measure by Kaufmann et al. (2009) is better since it allows for variation over time within the countries. Following Riccardi et al. (2018), the sample is divided into countries with high regulatory quality and countries with low
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regulatory quality. The cutoff between high and low regulatory quality is based on the sample median. Riccardi et al. (2018) found that this appropriately distinguishes high regulatory quality from low regulatory quality. Companies in countries where the regulatory quality is above the median are classified as high regulatory quality, whereas companies in countries where the regulatory quality is equal to or below the median are classified as low regulatory quality. This means that the measurement of this variable is categorical. The independent variable ‘audit firm’ used for testing H2 is also a categorical variable.
Dependent variable
The dependent variable ‘nature of the KAM’s’ refers to which category each KAM was put into. In the original database, ten categories were used to classify the KAM’s and some categories were further split up into subcategories. These categories can be seen in appendix A. Table A1 shows the categories that were used and table A2 shows the distribution of the categories of category level 1 and 2. Research from Brouwer et al. (2016) showed that by far the most KAM’s are related to the balance sheet (66%). This is also the case for the data used in this research, since roughly 60% of the KAM’s relate to the balance sheet2. In order to
distribute the number of KAM’s more evenly among the categories, some categories were merged while others were split up. The final categories that were used to test the hypotheses are shown in table 2.
2 See table A2 in Appendix A for how the KAM’s were originally categorized and the related distribution of the KAM’s for category level 1 and 2.
18
Control variable
The control variable firm size of the audited company was included in this research to investigate if the analyses yield the same result after controlling for the firm size. This variable is often used in recent auditing research (Velte 2018). There is expected to be a relationship between firm size and nature of the KAM’s, since there is often a positive relation between firm size and audit firm size and this suggests increased audit resources (Velte 2018). In order to perform the analyses, the variable is transformed into a categorical variable instead of a continuous variable. The reason for this is that the chi-square test of independence requires the control variable to be categorical. To this end, companies are classified as either big or small. The basis for firm size is total assets. Dang et al. (2018), who examined 100 papers from top financial, accounting and economic journals, found that total assets is one of the most popular proxies for firm size. In order to divide the companies in the samples evenly, the median of total assets is used as the cutoff (for H1: 10,043,380,000 USD; for H2: 10,137,900,000 USD).
19 RESULTS
The first hypothesis (H1) examines the effect of regulatory quality on the nature of the KAM’s. Specifically, a chi-square test of independence was performed to compare the nature of the KAM’s, which was measured by categorizing the KAM’s into one of six categories, in countries with high regulatory quality and low regulatory quality. The result of this test is that a significant interaction was found (𝑋𝑋2(5) = 15.602, 𝑝𝑝 = 0.008). This means that there is a
statistically significant association between regulatory quality and the nature of the KAM’s. Therefore, hypothesis 1 can be confirmed. Table 3 shows the results of the cross tabulation. As can be seen in the table, in countries with high regulatory quality, more KAM’s are reported in the categories ‘entity’ (11% versus 9.6%), ‘liabilities’ (17.2% versus 15.8%), ‘non-current assets’ (19.8% versus 19.6%) and ‘other’ (23.3% versus 18.6%). In low regulatory quality countries, relatively more KAM’s are reported in the categories ‘other assets’ (26.4% versus 21.1%) and ‘P&L’ (10% versus 7.6%).
The second hypothesis (H2) examines the association between the audit firm and the nature of the KAM’s. In order to do this, the same method was applied as with H1, so a cross tabulation with chi-square was performed. The test yields a significant interaction (𝑋𝑋2(15) =
39.173, 𝑝𝑝 = 0.001). The result is that there appears to be a statistically significant association between the audit firm and the reported KAM’s and hypothesis 2 can be confirmed. Table 4 shows the cross tabulation that was performed between the audit firm and the categories of the KAM’s. It can be seen that there exist some large differences between firms and the nature of the KAM’s that are reported. For example, 9.2% of the KAM’s that are reported by Deloitte
20
are in the category ‘P&L’, whereas EY only reports 5.2% of their KAM’s in the same category. Another notable difference exists between Deloitte and KPMG, as 20.9% of the reported KAM’s by KPMG fall into the category ‘liabilities’, whereas this is the case for only 8.6% of the reported KAM’s by Deloitte.
To examine if the significant results persist after controlling for firm size, a three-way cross tabulation was performed for the relationship between regulatory quality and nature of the KAM’s. The result of the chi-square test indicates that among big firms, there is a significant relationship between regulatory quality and nature of the KAM’s (𝑋𝑋2(5) =
11.762, 𝑝𝑝 = 0.038). This is also the case for small firms, as the chi-square test indicates that the relationship between regulatory quality and nature of the KAM’s for small firms is also significant (𝑋𝑋2(5) = 14.939, 𝑝𝑝 = 0.011). Therefore, the results suggest that the significant
relationship persists and that hypothesis 1 can be accepted, even after controlling for firm size. The three-way cross tabulation was also performed for the relationship between audit firm and the nature of the KAM’s. The significant effect of the audit firm on the nature of the KAM’s persists for big firms, as the chi-square test shows a significant results (𝑋𝑋2(15) = 33.014, 𝑝𝑝 =
0.005). However, for small firms there seems to be no significant effect between the audit firm and nature of the KAM’s (𝑋𝑋2(15) = 19.831, 𝑝𝑝 = 0.179). This means that after controlling for
21
firm size, hypothesis 2 can only be partially accepted. The audit firm only has an effect on the nature of the KAM’s for big firms according to these results.
DISCUSSION
For a long time, the auditor’s report contained standardized text and boilerplate language, providing very little informative value about the financial statements that were audited. The activities of the auditor in relation with the performed audits were a black box, but stakeholders expect more information from the auditor. As an answer to this information need, the new extended auditor’s report was implemented. This research is part of a growing body of research that examines the key audit matters that are reported in the new auditor’s report. It examines the association between regulatory oversight and the nature of key audit matters and the association between audit firms and key audit matters.
The results show that, for the categorization used in this research, there seems to be a significant association between regulatory oversight and the nature of key audit matters. This means that the new regulations and standards have different impact on different countries. This could be a result of the fact that enforcement of the new auditing standards in countries with high regulatory oversight is higher, therefore affecting the way in which auditors interpret the new standards. These variations in interpretation due to regulatory oversight might have resulted in different types of KAM being identified. Another reason why the association could be significant is because countries with a certain degree of regulatory oversight might also have other institutional characteristics that highly correlate with regulatory oversight. In other words, for example low regulatory oversight might me typical for countries with a weak economy. It is likely that companies operating in countries with a weak economy are subject to different risks than companies operating in countries with a strong economy. As a consequence, auditors report different kinds of key audit matters because they are related to the risks that are inherent to operating in weak or strong economies. The fact remains that this research provides evidence that standards can have varying effects on audit outcomes in different countries. It is important for policy makers and standard setters to realize this, so that if necessary adaptations can be made to country-specific regulations if need be.
The results also show that there is a significant association between the audit firm and the nature of the key audit matters, but only for relatively big clients. Considering the notion that audit firms each have their individual style and way of implementing new standards and guidelines (Kothari et al. 2010; Francis et al. 2014), this could implicate that the style effects do not affect small clients. However, this research does not investigate if the differences
22
between audit firms are caused by style. There are likely other factors in play as to why the audit firm only significantly affects the nature of KAM’s for big clients. Still, audit firms have an attention drawing role when they report KAM’s and they can influence to which aspects of the financial statements users are drawn (Backhuijs and Roelofsen 2014). The results of this research suggest that Big 4 audit firms vary in terms of the KAM’s they report and their nature, but only for big firms. Therefore, the attention drawing role is also affected by the individual audit firm. It might be useful for financial statement users to be aware of the fact that different audit firms might report different KAM’s, therefore affecting the way in which they use the financial statements.
Limitations
This research is subject to some limitations. The first one is related to the categorization of the key audit matters. There are numerous ways in which KAM’s could be classified. For instance, a report by the Association of Chartered Certified Accountants (ACCA 2018) that examined the first year application of the new standards related to the new auditor’s report used a typology that was loosely based on the methodology of the UK Financial Reporting Council. The typology of those reports do not use categories and subsequent levels of categories such as in this research, but defined a large number of types and classified the KAM’s accordingly. Moreover, some of the types used in those reports are not even used in the database for this research. While the categories used in this research are slightly similar to those of Brouwer et al. (2016), there are still many differences. For example, Brouwer et al. (2016) found that KAM’s related to tax position are most frequently reported. However, in the database used for this research KAM’s related to tax position were first classified as either assets or liabilities (category level 1), then as current assets or current liabilities (category level 2) and then finally as taxation (category level 3). Furthermore, KAM’s concerning taxation that were unrelated to the balance sheet had their own category.3 Because of this, KAM’s related to tax position are
scattered across many categories and therefore appear not as prominently as in Brouwer et al.’s (2016) research. Another category of KAM’s that seems underexposed in this research is IT-related KAM’s. Sneller et al. (2017) found that 15% of all KAM’s were IT-related to IT. Although their research only examined 25 Dutch companies, which means that their sample was significantly smaller and did not examine cross-country differences, it is still noteworthy that
3 See Appendix A, table A1 for a complete overview of all the categories and their levels that were used in the database for data collection.
23
they found such a large number of KAM’s to be related to IT. In the database used for this research, IT-related matters were categorized under ‘entity’, so no separate category was used. The findings from Sneller et al. (2017) might implicate that such a category should be implemented, since IT-related matters are so prevalent in that research. It can be concluded that there is not yet a standard on how to best categorize the KAM’s. Many different variations and typologies are used. The results that were found in this research can therefore only be seen in the context of the specific categorization that was used for this particular research. Other typologies might yield different results.
Secondly, this research does not take into account underlying factors that might influence the nature of the reported KAM’s. For example, the reason that one audit firm reports relatively more KAM’s of a certain type than the other, might be due to the fact that audit firms specialize in specific industries. Auditors that do this are expected to perform higher quality audits (Reichelt and Wang 2010) and it might be the case that the industry in which auditor clients operate result in different kinds of significant risks, which results in different types of KAM reported in the auditor’s report.
Thirdly, the way in which the data related to the nature of the KAM’s were collected might impact our overall inferences. The KAM’s were examined by students and then categorized. Since this is primarily based on judgement, KAM’s might not have been consistently classified. This is amplified by the ambiguity that is present in many KAM’s. To illustrate this, goodwill is often reported as a KAM. However, it is not a rare occurrence that goodwill and non-current assets such as plants, property and equipment are reported in the same KAM. This means that one KAM touches upon two different categories. In that case it is up to the data collector to decide in which category to put this specific KAM. This ambiguity might affect the data and consequently the results of this research.
Fourthly, the variable ‘regulatory quality’ is cutoff at the median to separate between high and low quality of regulatory oversight, but it is possible that this does not appropriately distinguish high and low regulatory oversight countries. Furthermore, the institutional environment of a country consists of more than only regulatory quality. It is possible that countries with weak regulatory quality score high on other institutional characteristics and the other way around. This potentially limits this research, as other measures of institutional quality could also be used in relation with the nature of the KAM’s.
24 Future research
This research focusses on the key audit matters in the auditor’s report, but there are many other avenues for future research related to the new auditor’s report that could be explored. For example, because this research does not make any inferences about the usefulness of the new auditor’s report and the key audit matters and previous research shows mixed results regarding the benefits of the additional requirements in the auditor’s report, further research is warranted in order to provide more conclusive evidence. The fact that the new auditor’s report is being implemented in an increasing amount of countries provides more opportunities to investigate the effects of the extended report, in a wide variety of settings. Other differences than regulatory oversight might also be examined in relation to the new auditor’s report in the future. Furthermore, future research could be conducted in order to establish a sound and universal framework for classifying key audit matters, since typologies in the reports and research are quite different (ACCA 2018; Brouwer et al. 2016; KPMG 2017).
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30 APPENDIX A
Table A1 shows the categories that were used to categorize the KAM’s in the original database that was used for this research.
TABLE A1 Original KAM categories
Category level 1 Category level 2 Category level 3
1. Assets Goodwill
Current assets Current assets Taxation Non-current assets Expenses 2. Liabilities Non-current liabilities
Current liabilities Current liabilities
Taxation 3. P&L (Profit & Loss) Revenues
Expenses 4. Acquisitions
5. Taxation 6. Entity
7. Fraud Fraud Explicit Fraud
Revenues Explicit Fraud Implicit Fraud 8. External
9. Valuation financial instruments 10. Other
